The allure of passive investments

In a low-return world, where double-digit returns from investments are the exception and not the norm, investment fees come under pressure and the demand for high-return investments increases.

The demand for lower fees is a common theme among investors, and one of the key attractions of passive investments, Hywel George, the director of investments at Old Mutual Investment Group, told delegates at this year's Financial Planning Institute (FPI) convention.

A passive investment passively follows a market index, unlike an active investment, in which investment allocation is actively controlled by a fund manager.

Globally, the growth of passive investments has been nothing short of phenomenal, George says. The three largest mutual (unit trust) funds in the United States are passive funds. Over the past five years, passive investments’ share of the investment market has grown from 17 percent to 23 percent: growth of 35 percent a year.

In South Africa, in the last 10 years, passive investments have grown by about 51 percent a year.

This trend is expected to continue as investors demand lower costs, one of the main drivers behind the growth of passive investments. Another driver is the under-performance of active managers, although George says that last year was the first time active managers in South Africa had really underperformed their benchmarks.

Because we are in a low-return environment, the challenge to add alpha (what an active manager can achieve over and above what the market achieves) is “extraordinarily difficult over long periods of time,” George said. A recent study showed that 99 percent of global equity active products under-performed their benchmark.

But the trend is not expected to continue to the point where there are only passive investments in the market, George says, because, as more passive investments are bought, the opportunity for active managers to outperform is greater.

He says that before selecting a passive investment, you must make sure it can deliver on its promise: first, check that the cost is lower than a comparable actively managed fund, and then check to see if it has the potential to deliver reasonable returns.

George and the team at Old Mutual Investments designed a balanced passive portfolio and back-tested it to 2005. The passive portfolio delivered an average annual return of 12.4 percent, compared to an actively managed balanced fund, which delivered 11.7 percent.

Does this mean we should invest all our assets in passive funds? George says he wouldn’t advocate a 100-percent allocation to passive funds, and would still have some products that could deliver alpha. But you can blend the two strategies and achieve a good outcome.

If you have a third of an investment managed passively and the remaining two-thirds managed actively, you can beat the returns of an average balanced fund and reduce fees by 20 percent, statistics from Old Mutual show.

REAL ASSETS

Another trend George highlighted at the conference is the shift to investing in “real assets”. Real assets include infrastructure, private equity (companies not listed on the stock exchange), agriculture and real estate.

Real assets are not liquid investments, and if you invest you need to make sure that whoever manages the investment knows what they are doing. If it goes wrong, it can go horribly wrong, George warns. However, these investments can generate alpha, and their correlation to equities is generally low.

Private equity is high risk, as it typically involves smaller business or companies in a turnaround phase, where the risk of failure is high.

In South Africa, private equity has outperformed the South African listed equity market over 10 years: the latest RisCuraSAVCA South Africa Private Equity Performance Report shows that for the 10 years ending December 31 2015, private equity returned 18.5 percent versus the FTSE/JSE All Share return of 14.1 percent.

However, these are average figures and there can be very wide variation in returns. Investing in private equity, or any real asset, is not a decision to be taken lightly, as there is no regulation and investors bear all the risk, George says.